Perfect competition is a situation in which all buyers and sellers are price takers.

29Monopolistic Competition

Monopolistic competition is a situation in which individual producers can act as price setters

there is some competition

but a number of sellers is smaller

and standardization of the product is imperfect.

30Monopolistic Competition (continued)

Keynesians point out that a relatively small part of the economy is perfectly competitive.

31Monopolistic Competition (continued)

A price-setter

sets a price in nominal terms for some period of time

meets the demand that is forthcoming at the fixed nominal price

readjusts its price from time to time.

32Menu Cost and Price Setting

A menu cost is a cost of changing prices.

If the loss in profits is less than the cost of changing prices menu cost the firm will not change its price.

33Empirical Evidence of Price Stickiness

Major reasons of price stickiness are menu costs and a reluctance of managers to lead price changes.

A pass-through from the exchange rate to domestic prices is slow or incomplete.

34Meeting the Demand at the Fixed Nominal Price

A monopolistically competitive firm charges a price higher than its marginal cost (at a markup).

When prices are sticky, firms react to changes in demand by changing the amount of production, rather than changing prices.

35Meeting the Demand (continued)

The economy can produce an amount of output that is not on the full-employment line.

36Keynesian Business Cycle Theory

Keynesians believe that a primary source of business cycle fluctuations is unanticipated shifts in the aggregate demand curve aggregate demand shocks.

Keynesians attribute recessions to not enough demand for goods.

37Keynesian Business Cycle Theory (continued)

The Keynesian theory accounts for several business cycle facts

recurrent fluctuations of Y in response to AD shocks

employment fluctuates in the same direction as Y

shocks to M are non-neutral, money is procyclical and leading.

38(No Transcript) 39Keynesian Business Cycle Theory (continued)

Cyclical behaviour of durable and investment goods can be explained if shocks to them are themselves a main source of cycles.

40Keynesian Business Cycle Theory (continued)

Inflation tends to slow during or just after recessions because demand pressure is low during recessions.

41Procyclical Labour Productivity

This approach has a problem to explain the fact that labour productivity is procyclical.

If the production function is stable, increases in employment during booms should reduce average labour productivity, so it should be countercyclical.

42Procyclical Labour Productivity (continued)

Firms may hoard labour during recessions and use it less intensively. So, labour productivity falls during a recession.

Labour hoarding is found to be reduced in the last two recessions in Canada.

43Macroeconomic Stabilization

According to Keynesians recessions are undesirable, employment can be below the amount of labour that workers want to supply.

44Macroeconomic Stabilization (continued)

Average economic well-being would be increased if governments tried to reduce cyclical fluctuations.

45Macroeconomic Stabilization (continued)

Under no AD policy wages and prices will be eventually cut in the long run.

While the adjustment process takes place economic well-being is reduced.

46Macroeconomic Stabilization (continued)

If prices adjust slowly and the fiscal or monetary policies can be implemented quickly, the AD policy could move the economy back to full-employment output more quickly than doing nothing.

47Difficulties of the Policy of Macroeconomic Stabilization

Actual macroeconomic stabilization is less successful than Keynesian theory suggests

monetary and fiscal policies should be coordinated

depth of a recession is difficult to measure

the size of effects of monetary and fiscal policies is not known.

48Difficulties of the Policy (continued)

Monetary and fiscal policies have lags.

Policymakers should concentrate of fighting major recessions.

Policymakers should be willing to take economic advice.

49Supply Shocks in the Keynesian Model

In 1970s Keynesian theory failed to account for the stagflation.

The theory predicts that inflation movements are procyclical.

50Supply Shocks (continued)

Keynesians admit that there can be occasional episodes when supply shocks play a primary role in economic downturns.

An adverse supply shock reduces MPN and demand for labor. The FE line and LRAS curve shift to the left.

51Supply Shocks (continued)

The adjustment takes place slowly.

In the long run, full-employment output falls, the price level and the real interest rate increase.

52Supply Shocks (continued)

In the situation of adverse supply shock fiscal and monetary policies can offer little help.

An unanticipated contractionary AD policy can reduce the size of increase in the price level, but it can cause a fall in output below the new full-employment level.

53(No Transcript) 54(No Transcript) 55End of Chapter

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